An Introduction To Look-Through Earnings

{ Euclidean Q3 2011 Letter }

Since inception on August 7th 2008, Euclidean has delivered annualized net returns of +10% in the context of a market that is slightly down. In this sense, we are pleased with our long-term performance and view it as emerging validation of our systematic approach to long-term investing. Our degree of outperformance, however, was much higher at the start of this year. The market value of our portfolio has declined in both absolute and relative terms during 2011.

In prior letters, we communicated that we expect to have times like these when we have negative or below average short-term results. As we are in the midst of such a period, we feel it is important to share information that may be helpful to you in assessing the value of what you own as a long-term Euclidean investor.

Thought Experiment: A Family Asset and a New Market Price

Here is a thought experiment that frames how we evaluate the intrinsic value of our portfolio and provides a basis for thinking about short-term swings in market prices.

Imagine your family owns an apartment building that is mostly occupied, as it has consistently been for the past 20 years. Each year, after repairs and maintenance, the building provides your family $1,000,000 that you can spend or invest however you choose. What would this building be worth to you?

Now imagine that your neighbor owns an identical building that also generates $1,000,000 in annual distributable cash. After signs of an impending economic downturn, your neighbor becomes anxious and offers to sell his building for $4,500,000, effectively establishing a market price for your building at the same amount.

Your building continues to generate $1,000,000 each year for you. Would you consider selling your building at the new market price of $4,500,000? What if someone offered you $5,000,000 as a premium to the market price?

In a situation such as this, it may be helpful to think about what you would do with the proceeds if you sold your building. One option would be the ‘risk-free’ choice of buying very short-term US Treasury debt. Treasury Bills, which mature in 1-year, currently yield 0.1%. So, ignoring any taxes on the sale, if your family sold the apartment building for $5,000,000 and used the proceeds to purchase T-Bills, you would generate $5,000 a year.

Whoa. $5,000 in free cash flow would be a lot less than the $1,000,000 your family is currently earning from the building. Perhaps this disparity reflects a general sense that the fundamental economics – occupancy and rent levels -- of your apartment building are likely to degrade. When economic times are challenging, this kind of fear is not uncommon and perhaps, over the short-term, not misplaced. Still, if you are not desperate for cash and are investing for the long-term, we believe it would only make sense to trade your current $1,000,000 earning stream for a $5,000 earning trickle if you believe your building will never return to the levels of performance it consistently delivered for the past several decades. After all, it takes a lot of years making $5,000 to equal one $1,000,000 year.

As time passes, it will become clear whether you should have sold or kept the building. Unfortunately, investment decisions need to be made in present time without being able to divine the future. There are always unknowns. Thus, it makes sense to proceed with a margin of safety. A margin of safety is achieved by making choices where, even if a lot goes wrong, you can still preserve and grow capital over the long-term.

In the case of our fictional apartment building, it would be the buyer of your building, not you as the seller, who is operating with a substantial margin of safety. Even if 70% of the apartment building’s earnings power went away and never returned, he would generate 60x the income he would otherwise have earned from owning T-Bills. (Certainly he could have put his proceeds into other assets with higher yields than T-Bills, but those choices would have risks that might prove more real than the risks associated with owning the apartment building.)

So, perhaps you rethink the opportunity. Maybe you keep your family’s building and instead explore how you might purchase your neighbor’s apartments across the street. After all, in a world of very low interest rates, assets like your building should not be priced to yield 20% ($1,000,000 in cash flow divided by $5,000,000 purchase price) for very long.

Look-Through Earnings – What Does This Concept Mean?

Euclidean’s systematic process is focused on finding companies that resemble our fictional apartment building. We seek companies that have strong historic fundamentals as well as very low prices (and thus, very high Earnings Yields).

We do not look to our short-term returns to evaluate how well we are achieving this goal. Rather, we focus on our portfolio’s evolving ‘look-through’ earnings, which we believe to be the primary driver of Euclidean’s long-term performance.

Our process for generating look-through earnings might be thought of as analogous to a business that has 30 divisions. At the end of each period, that business would consolidate the financial results of all 30 divisions into one set of financial statements. If you owned this diversified business, you would pay attention to the performance of each division and you would care greatly about how much cash you could pocket across all divisions each year. Your wealth would increase to the extent that your aggregate owner earnings stream increased at a rate exceeding inflation over the long-term.

This describes what Euclidean monitors on an ongoing basis. At Euclidean, we own shares in approximately 30 holdings. If a given portfolio company has $300M market value and we own $3M worth of its shares, then we own 1% of that business. So, to create our consolidated look-through financials, we take 1% of that business’s revenue, cash, debt, earnings and so on, and combine that with our pro-rata share of our other holdings’ financials. These look-through earnings help us understand the same things that our fictional CEO with 30 divisions, or our apartment building owner, would care a lot about - How much annual, discretionary cash flow do we have? How does our balance sheet look? Is the business growing?

The answers to these questions matter because – to paraphrase Benjamin Graham – in the short-run, the market behaves like a voting machine but over the long-run, the market more closely resembles a weighing machine. Graham’s point is that fear, greed, and other emotions (the voting machine) can drive short-term market fluctuations that cause disconnects between the price and true value of companies’ shares. Over long periods of time, however, the weighing machine takes over as companies’ underlying business results ultimately cause the value and market price of their shares to converge.

The Look-Through Metrics

The numbers below help us understand our portfolio companies’ underlying business results in context of their market prices.

Prior to reviewing these numbers, please understand that Euclidean uses similar concepts but different measures to assess individual companies as potential investments. Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth. Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade-offs between measures, and so on.

We share the numbers below because they are simple, easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale. In general, higher numbers for these measures are more attractive. The key measures are:

Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields. Earnings Yield reflects a company’s past four-year average earnings before interest and tax divided by its current enterprise value (enterprise value = market value + debt – cash).

Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) into the business. To fully describe the importance of high returns on capital requires a letter of its own. At its highest level, this measure reflects two important things. First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders. Second, it indicates whether management has good discipline in deciding what to do with the cash it generates. For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy in their businesses, will show lower returns on capital than businesses that do the opposite. Return on Capital reflects a company’s four-year average earnings before interest and tax, divided by its current equity + long-term debt.

Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others. High numbers here imply that the company owns a large portion of its figurative ‘house’ and, all else being equal, often indicates a better readiness to weather tough times.

Revenue Growth Rate – This shows the annualized rate that a company has grown across the past four years.

What do you take away from these numbers? First, look at Earnings Yield as a key valuation measure. There is a big difference between a 22% and a 9% Earnings Yield. The implication is that for the four-year average earnings of our portfolio to be valued similarly to the S&P 500’s average earnings, our portfolio would have to appreciate by 140%. (1) (2)

There can be good reasons for this kind of discrepancy. Certain companies rightly command premium multiples because of strong proprietary brands, a diversity of earnings streams, or a bounty of important patents. Other reasons for premium valuations might include faster than average growth, a stronger than average balance sheet, or (perhaps via strong brands, important patents or good management) high returns on the capital invested in its business.

Yet, by looking at the measures above, there is a disconnect. Our portfolio is selling at a substantial discount to market, and yet it consists of companies with certain qualities that might make them more valuable than average. Specifically, our portfolio companies as a whole have been growing faster, are more conservatively financed, and have historically had stronger wealth creation engines than the S&P 500.

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So, as a partner in Euclidean, much like our apartment building owner, you own something of value. We should welcome this market volatility as an opportunity to buy other market participants’ shares, at half price, in this collection of companies with materially better-than-average fundamentals.

[1] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials. That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on. Then, it sums those numbers with its pro-rata share of all other portfolio companies. This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures for earnings yield, return on capital, equity to assets, and revenue growth.

[2] The S&P 500 measures are calculated in a similar way as described in the prior footnote. The market values, revenue, debt, assets, earnings, etc. for each company in the S&P 500 are added together. Those aggregate numbers are then used to calculate the metrics above. For example, the earnings yield of the S&P 500 is calculated as the total average 4-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).

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